ADVANCE NOTICE PROVIDES TEMPORARY GUIDANCE FOR DEFERRED COMPENSATION PLAN DISTRIBUTIONS AND DEDUCTIONS.

Notice 87-13

This notice provides guidance, in the form of questions and answers, with respect to certain provisions of the Tax Reform Act of 1986 (TRA '86) dealing with the annual limit on elective deferrals under section 402(9) of the Internal Revenue Code, the rules governing the taxation of qualified plan distributions under section 72, the rollover rule for partial distributions under section 402(a)(5), the 50 percent estate tax deduction for sales of employer securities to employee stock ownership plans under section 2057, the transition rule under which certain lump sum distributions received before March 16, 1987 may be treated as received in 1986, and the extension of section 457 to deferred compensation plans of tax-exempt organizations.

Until further guidance is published, the guidance provided by these questions and answers may be relied on by taxpayers to design and administer plans and to determine the tax treatment of plan contributions and distributions. The Service will apply the questions and answers in issuing determination letters, opinion letters, and other rulings and in auditing returns with respect to taxpayers and plans. If future guidance is more restrictive then this notice, such guidance will be applied without retroactive effect. No inference should be drawn, however, regarding issues not addressed in this notice which may be suggested by a particular question and answer or as to why certain questions, and not others, are included. Retroactive protection will not necessarily be afforded with respect to any such inferred guidance. Many issues relating to the rules discussed in this notice are not addressed in this notice. Further guidance will be provided regarding many of these issues.

A. CODE SECTION 402(g) (TRA '86 SEC. 1105)

Q-1: What does section 402(g) of the Code provide?

A-1: Section 1105 of TRA '86 adds section 402(g) to the Code to limit the extent to which an individual's elective deferrals under a qualified cash or deferred arrangement (section 401(k)), a tax- sheltered annuity program (section 403(b)), or a simplified employee pension (section 408(k)) for a taxable year of the individual may be excluded from the individual's gross income for such year under sections 402(a)(8), 403(b), and 402(h), respectively.

The annual limit on the exclusion of elective deferrals under sections 402(a)(8), 403(b), and 402(h) for any taxable year of an individual is $7,000 (indexed beginning in 1988 as provided under section 415(d)). This $7,000 amount is increased (but not above $9,500) for any taxable year of an individual to the extent that the individual has elective deferrals excluded under section 403(b) for such year. Thus, for example, an individual may have $7,000 in elective deferrals under a cash or deferred arrangement and an additional $2,500 in elective deferrals under a tax-sheltered annuity for the same year. The $7,000/$9,500 limit (as it applies to elective deferrals under section 403(b)) is increased for certain long-service individuals employed b certain tax-exempt organizations under section 402(g)(8). Special rules under sections 457(c)(2) and 501(c)(18)(D) coordinate amounts deferred under section 457 and elective deferrals under section 501(c)(18) with the section 402(g) limits.

Section 402(g) also provides special rules permitting the distribution of excess elective deferrals for a year by April 15 of the following calendar year. Only elective deferrals that are included in the gross income of an individual on account of the section 402(g) limit may be distributed under these rules. In addition, even though excess elective deferrals are distributed under these special rules, such excess elective deferrals are taken into account under section 415, section 401(k)(3), and any other nondiscrimination test applicable to elective deferrals. Future guidance will limit the extent to which excess elective deferrals by employees who are not highly compensated employees (as defined in section 414(q)) may be taken into account under section 401(k)(3) and other nondiscrimination rules.

Q-2: Which elective deferrals are subject to section 402(g)?

A-2: Section 402(g) limits the otherwise permitted exclusion from gross income of elective deferrals of individuals under section 402(a)(8), section 402(h)(1)(B), and section 403(b). These sections permit individuals to avoid constructive receipt on amounts deferred at their elections under qualified cash or deferred arrangements, simplified employee pensions, and tax-sheltered annuities, respectively. Thus, for purposes of applying section 402(g) to an individual's elective deferrals for a taxable year of the individual, any deferrals that, but for sections 402(a)(8), 402(h)(1)(B), and 403(b), would have been received or treated as received by the individual (and thus included in the individual's gross income) for the taxable year are to be treated as elective deferrals for such year.

EXAMPLE. Assume that a participant in a qualified cash or deferred arrangement is permitted to elect, on or before December 31, 1987, to defer a specified percentage of regular salary for 1988. The employee elects to defer 10 percent of his otherwise payable salary for 1988. But for section 402(a)(8), such elective deferrals would have been treated as received by the employee during 1988, i.e., when they would have been actually received but for the deferral. Accordingly, such elective deferrals are subject to the section 402(g) limit for the employee's 1988 taxable year.

Q-3: When is section 402(g) effective?

A-3: Section 402(g) applies to elective deferrals for taxable years of individuals beginning after December 31, 1986. However, a special rule defers the effective date for an individual's elective deferrals made pursuant to a collective bargaining agreement between employee representatives and one or more employers that was ratified before March 1, 1986. The special rule provides that section 402(g) does not apply to such elective deferrals for an individual's taxable years beginning before the earlier of (i) the termination date of the collective bargaining agreement with respect to which the elective deferral is made, or (ii) January 1, 1989. The termination date of a collective bargaining agreement is to be determined without regard to any extension thereof after February 28, 1986. See Q&A-4 for application of these effective dates to an individual who makes both elective deferrals pursuant to a collective bargaining agreement and elective deferrals not pursuant to a collective bargaining agreement. See Q&A-6 6 Q&A-7 for a transition rule relating to partners of fiscal year partnerships, and Q&A-8 & Q&A-9 for a transition rule relating to elective deferrals of 1987 payments attributable to 1986 services.

EXAMPLE 1. An employee is represented by Union A and, under the terms of the collective bargaining agreement negotiated by Union A with the employer, such employee is eligible to make elective deferrals under a qualified cash or deferred arrangement maintained by the employer. The collective bargaining agreement was ratified on November 1, 1985 and will terminate on October 31, 1988. The employee's taxable year is the calendar year. Because October 31, 1988 is the termination date of the collective bargaining agreement under which the employee's elective deferrals are made, the elective deferrals made by the employee out of amounts that would have been received by the employee in calendar year 1987 and 1988 (but for section 402(a)(8)) ar not subject to section 402(g). However, the employee's elective deferrals out of amounts that would have been received by the employee in calendar year 1989 (but for section 402(a)(8)) will be subject to section 402(g).

EXAMPLE 2. Assume the same facts as example 1, except that the employer permits employees who are not represented by Union A or by any other union also to make elective deferrals under the same qualified cash or deferred arrangement. Even though such employees participate in the same qualified cash or deferred arrangement as the employees who are represented by Union A (and without regard to the percentage of the total eligible employees under the arrangement that is represented by Union A or any other union), the elective deferrals made by such employees do not qualify for the special rule deferring the effective date. Thus, such employees' elective deferrals for taxable years beginning after December 31, 1986 are subject to section 402(g).

EXAMPLE 3. Assume the same facts as example 1, except that employees who are represented by Union B also participate in the same qualified cash or deferred arrangement. The participation of these employees in the arrangement was negotiated under a collective bargaining agreement ratified on January 1, 1984 and scheduled to terminate on December 31, 1987. Even though Union A's collective bargaining agreement will not terminate until October 31, 1988, the elective deferrals of the employees represented by Union B out of amounts that would have been received during calendar year 1988 (but for section 402(a)(8)) will be subject to section 402(g).

Q-4: How does section 402(g) apply to an individual who has two classes of elective deferrals under qualified cash or deferred arrangements if one class of elective deferrals is pursuant to a collective bargaining agreement and the other class is not pursuant to a collective bargaining agreement?

A-4: Section 402(g) applies to elective deferrals that are not pursuant to a collective bargaining agreement for taxable years of the individual taxpayer beginning after December 31, 1986. This is the case even if such elective deferrals are under a cash or deferred arrangement to which all other elective deferrals for all other participants are pursuant to a collective bargaining agreement. Also, this is the case even if the individual taxpayer also has elective deferrals pursuant to a collective bargaining agreement under the same or a different cash or deferred arrangement and section 402(g) does not apply to such other deferrals until a subsequent taxable year. In addition, in determining the extent to which an individual's elective deferrals that are not pursuant to a collective bargaining agreement are in excess of the section 402(g) limit, elective deferrals that are pursuant to such an agreement are taken into account and thus are applied against the limit before the elective deferrals not pursuant to such an agreement.

EXAMPLE. For calendar year 1987, an employee has $3,000 in elective deferrals pursuant to a collective bargaining agreement that is scheduled to terminate on June 30, 1988 and $6,000 in elective deferrals that are not pursuant to a collective bargaining agreement. In applying the $7,000 limit under section 402(g) for 1987 to this employee, the employee is treated as having $2,000 in excess deferrals. If the employee had $8,000 (rather than $3,000) in elective deferrals pursuant to the collective bargaining agreement, the employee would be treated as having $6,000 in excess deferrals for calendar year 1987.

Q-5: How does section 402(g) apply to a qualified cash or deferred arrangement that is part of a qualified plan with a plan year other than the calendar year?

A-5: Section 402(g) limits the otherwise permitted exclusion from gross income of elective deferrals by individual taxpayers under sections 402(a)(8), 402(h)(1)(B), and 403(b). Section 402(g) thus applies on the basis of the individual taxpayer's taxable year to amounts that would have been received or treated as received (and thus included in the individual's income) for such year but for the application of one of these exclusions. Section 402(g) applies without regard to the plan year of the cash or deferred arrangement or other plan or arrangement under which the elective deferral is made, without regard to when the employee elects to make the deferral, and without regard to when the elective deferral is contributed to the arrangement or plan. As a result, elective deferrals that are subject to the section 402(g) limit for a single taxable year of an individual taxpayer may relate to two different years for other purposes (e.g., nondiscrimination or section 415 purposes), and elective deferrals that relate to one plan year for certain purposes may be subject to the section 402(g) limit for two different taxable years of the individual taxpayer.

EXAMPLE. An employee with a calendar year taxable year is eligible to make elective deferrals under a qualified cash or deferred arrangement that is part of a qualified plan established on July 1, 1987 with a plan year ending June 30. Elective deferrals under the cash or deferred arrangement are made out of the employee's regular weekly salary. Elective deferrals made out of weekly salaries that would have been received by the employee in the last half of calendar year 1987 (i.e., after June 30, 1987) are subject to section 402(g) for calendar year 1987, and elective deferrals made out of weekly salaries that would have been received by the employee in the first half of calendar year 1988 (i.e., before June 30, 1988) are subject to section 402(g) for calendar year 1988. This is the case even if all of these elective deferrals are taken into account for the same plan year for purposes of applying section 401(k) and the other applicable qualification rules to the cash or deferred arrangement and the plan of which the arrangement is a part.

Q-6: How does section 402(g) apply to partners of a fiscal year partnership for the first taxable year of the partnership ending after December 31, 1986?

A-6: Section 1105(c)(4) of TRA '86 contains a special rule applicable to an individual taxpayer who is a partner in a fiscal year partnership if the first taxable year of the partnership ending after December 31, 1986 includes some portion of calendar year 1986. Under the special rule, solely for purposes of applying section 402(g) to such partner for such first taxable year of the partnership, the partner's elective deferrals are to be spread ratably over such entire first taxable year. But for this special rule, such elective deferrals would be treated as having occurred, for purposes of section 402(g), on the last day of the partnership year (i.e., the day on which such deferrals would have been treated as received for tax purposes by the partner but for the application of section 402(a)(8)).

This special rule applies without regard to (i) whether the qualified cash or deferred arrangement is part of a plan with a plan year that is the same as or different from the partnership's taxable year, (ii) whether the partnership uses a limitation year for purposes of section 415 that is the same as or different from the partnership's taxable year or the plan's plan year, (iii) whether the partner makes the deferral election in calendar year 1986, or (iv) when the elective deferral is contributed to the plan.

If an individual taxpayer with a calendar year taxable year (i) is a partner in a partnership with a fiscal taxable year that includes December 31, 1986, and (ii) does not have elective deferrals in excess of the "applicable amount" (as set forth in the following table) for the first taxable year of the partnership ending after December 31, 1986 with respect to qualified cash or deferred arrangements (and SEPs) maintained by the partnership, then no more than $7,000 of the elective deferrals for such first taxable year of the partnership under such qualified cash or deferred arrangements (and SEPs) will be allocable to the partner's 1987 taxable year for purposes of applying section 402(g). In such case, the partner will not be treated as having deferrals in excess of $7,000 for such first taxable year of the partnership with respect to cash or deferred arrangements (and SEPs) maintained by the partnership. The following "applicable amounts" apply only if such first taxable year of the partnership is twelve calendar months. Also, a partner may be precluded from having elective deferrals as large as an "applicable amount" on account of other limits (e.g., section 415).

          Close of the Partner-

EXAMPLE 1. An individual taxpayer with a calendar year taxable year is a partner in a partnership with a 12-month taxable year ending May 31, 1987. The partner participates in a qualified cash or deferred arrangement that is part of a plan with a plan year ending on May 31. For the partnership year ending May 31, 1987, the partner has $20,000 in elective deferrals. Under the special rule, 7/12ths of the $20,000 (i.e., $11,666.67) is allocable to the 1986 portion of the partnership's taxable year and thus is not subject to the section 402(g) limit for the partner's 1987 taxable year, and 5/12ths of the $20,000 (i.e., $8,333.33) is allocable to the 1987 portion of the partnership's taxable year and thus is subject to the section 402(g) limit for the partner's 1987 taxable year. Thus, $1,333.33 of the $20,000 in elective deferrals for the partnership year ending May 31, 1987 is treated as an excess deferral for the partner's 1987 taxable year. Nevertheless, the entire $20,000 elective deferral is to be taken into account for nondiscrimination and section 415 purposes under the generally applicable rules as though this special rule for purposes of applying section 402(g) did not apply.

EXAMPLE 2. Assume the same facts as example 1, except that the individual taxpayer also is a common law employee for an employer that is unrelated to the partnership and, as an employee of such unrelated employer, participates in a qualified cash or deferred arrangement maintained by such employer. For the calendar year 1987, the individual-employee has $2,000 in elective deferrals to the qualified cash or deferred arrangement of the employer. Thus, the individual taxpayer has a total of $10,333.33 in elective deferrals for his 1987 taxable year (i.e., $8,333.33 as a partner and $2,000 as an employee), which creates an excess deferral of $3,333.33 for calendar year 1987.

EXAMPLE 3. Assume the same facts as example 1, except that the partnership elects a short taxable year ending December 31, 1987 following its taxable year ending May 31, 1987. For the short taxable year, the partner has $4,000 in elective deferrals under the cash or deferred arrangement. Thus, the partner is treated as having a total of $12,333.33 ($8,333.33 plus $4,000) in elective deferrals for calendar year 1987, thereby generating an excess deferral of $5,333.33 for such partner's 1987 taxable year.

Q-7: Does section 1105(c)(4) of TRA '86 alter the otherwise applicable limits under section 402(g) or section 415?

A-7: No. Section 1105(c)(4) of TRA '86 does not alter any of the limits that apply to elective deferrals (including, for example, sections 402(g) and 415). Instead, merely for purposes of applying the generally applicable section 402(g) limit, section 1105(c)(4) reduces the extent to which elective deferrals for the first fiscal year of a partnership ending after 1986 are subject to the section 402(g) limit for 1987 by allocating a portion of such elective deferrals to the 1986 portion of such fiscal year. Relief is provided in this fashion because, unlike other limits, the section 402(g) limit applies on the basis of the individual partner's own taxable year to elective deferrals of the partner under all cash or deferred arrangements, SEPs, and tax-sheltered annuities in which the partner participates, including those maintained by unrelated employers or partnerships.

Q-8: How does section 402(g) apply to an elective deferral under a qualified cash or deferred arrangement of compensation attributable to service performed by the employee during 1986 but not payable to the employee until calendar year 1987?

A-8: Section 1105(c)(5) of TRA '86 provides a special rule for the treatment of certain elective deferrals for calendar year 1987 to the extent such deferrals are with respect to a qualified cash or deferred arrangement, are out of compensation (e.g., regular salary, commissions, and bonuses) attributable to 1986 service by the employee, and certain other conditions are satisfied (see Q&A-9). This special rule is not available for elective deferrals of an individual taxpayer as a partner in a partnership.

Elective deferrals within section 1105(c)(5) of TRA '86 are not subject to the section 402(g) limit for the first taxable year of the employee beginning after December 31, 1986, and will not be taken into account in applying section 402(g) to any other elective deferrals.

EXAMPLE. A calendar year employee participates in a qualified cash or deferred arrangement under which the employee is eligible to defer a portion of a bonus to be paid after December 31, 1986 and before January 31, 1987 and attributable to services performed by the employee in calendar year 1986. Before the end of 1986, the employee elects to defer the lesser of 50 percent or $10,000 of the bonus payment. Assuming that the bonus payment for this employee is at least $20,000, the employee has a $10,000 elective deferral with respect to the bonus payment. Under the general rule of section 402(g), this $10,000 elective deferral would be treated as an elective deferral for calendar year 1987 because it would have been received by the employee during calendar year 1987 (but for section 402(a)(8)). However, under the special rule of section 1105(c)(5) of TRA '86, the $10,000 is not subject to the section 402(g) limit for the 1987 calendar year.

Q-9: Which elective deferrals are within the special rule of section 1105(c)(5) of TRA '86?

A-9: The special rule of section 1105(c)(5) of TRA '86 is available for certain elective deferrals with respect to a qualified cash or deferred arrangement out of compensation that would have been received (but for section 402(a)(8)) during calendar year 1987 to the extent that such compensation is attributable to services performed by the employee during calendar year 1986. An employee's elective deferrals are not within the special rule of section 1105(c)(5) of TRA '86 unless each of the following conditions is satisfied:

(i) On August 16, 1986, the qualified cash or deferred arrangement permitted the employee to elect to defer all or a portion of compensation that is attributable to 1986 services and to be paid in 1987;

(ii) The elective deferral is out of compensation with respect to which, on August 16, 1986, the qualified cash or deferred arrangement permitted the employee to make a deferral election;

(iii) The elective deferral is pursuant to an election that, under the terms of the qualified cash or deferred arrangement on August 16, 1986, applied to the compensation out of which the elective deferral is made;

(iv) The elective deferral is pursuant to a deferral election that the employee actually made before January 1, 1987 by specifying the percentage or dollar amount of the compensation to be deferred;

(v) The elective deferral is out of compensation that is attributable to services performed by the employee during calendar year 1986;

(vi) The elective deferral is out of compensation that would have been received by the employee (but for section 402(a)(8)) during 1987;

(vii) The elective deferral is out of compensation that the employer maintaining the cash or deferred arrangement accrued (as determined for purposes of section 461) before January 1, 1987 (or would have accrued by such date if the employer actually used the accrual method of accounting);

(viii) The elective deferral is contributed during calendar year 1987 to the plan of which the qualified cash or deferred arrangement is a part; and

(ix) The elective deferral is taken into account for all other purposes (including nondiscrimination purposes under section 401(k)(3) and limitation purposes under section 415) for the plan or limitation year in the manner that it would have been taken into account under the terms, procedures, or practices of the plan on August 16, 1986, as if the special rule of section 1105(c)(5) of TRA '86 had not been enacted or did not apply to such deferral.

Q-10: Must a cash or deferred arrangement be amended to limit each individual's elective deferrals to the section 402(g) limit in order to satisfy sections 401(a) and 401(k)?

A-10: No. However, if an individual taxpayer makes elective deferrals in excess of the applicable limit for a taxable year under cash or deferred arrangements (and SEPs and tax-sheltered annuities) maintained by the same employer (determined after application of subsections (b), (c), (m), (n), and (o) of section 414), the employer will have employment tax liability with respect to such excess elective deferrals. For purposes of applying any such employment tax provisions, the first elective deferrals for a taxpayer's taxable year are treated as the excess deferrals for such year.

B. SECTION 72 OF THE CODE (SECTION 1122 OF TRA '86)

Q-11: How are the basis recovery rules of section 72(e) modified by TRA '86?

A-11: TRA '86 modifies section 72(e) as it applies to distributions before the annuity starting date ("nonannuity distributions") from trusts and contracts that are described in section 72(e)(5)(D) (other than individual retirement accounts and annuities) by providing that such distributions shall be included in gross income except to the extent they are allocable to the taxpayer's investment in the trust or contract. Section 72(e)(8)(B) provides that the portion of any distribution that is allocable to the taxpayer's investment in the trust or contract shall be (i) the portion of the distribution that bears the same ratio to the total distribution as (ii) the taxpayer's total investment in the trust or contract bears to the value of the vested portion of the taxpayer's total account balance in the trust or contract. For purposes of this determination, the value of a taxpayer's total account balance generally is to be the fair market value of the total assets under the account (including, e.g., net unrealized appreciation on employer securities that are not included in the distribution or distributions for which the basis recovery determination is being made), determined on a reasonable and consistent basis under the method that would be used by the plan for purposes of determining the amount of a total distribution of the employee's benefit under the plan.

In the case of a defined benefit plan, the present value of the vested portion of the total accrued benefit of a participant under the defined benefit plan (calculated using the plan's factors if the plan provides for a total distribution, and, in other cases, using the factors specified under section 20.2031-7 of the regulations) is to be treated as the value of the vested portion of the account balance.

If a distribution (or distributions) includes employer securities with respect to which net unrealized appreciation (NUA) is not currently taxable under either section 402(a)(1) or section 402(e)(4)(J), the value of the vested portion of the taxpayer's total account balance is to be reduced for purposes of determining the extent to which the non-NUA portion of the distribution (or distributions) is allocable to the taxpayer's investment in the trust or contract. The amount of the reduction is equal to value of the NUA portion of the distribution (or distributions) that is not currently taxable under section 402(a)(1) or section 402(e)(4)(J).

In the case of a trust or contract that was part of a plan that, on May 5, 1986, permitted distributions of any employee contributions before separation from service, the pro rata basis recovery rules of section 72(e) apply to nonannuity distributions under such trust or contract after December 31, 1986. See Q&A-13 for a special grandfather rule for investment in the contract on December 31, 1986 under such plans.

In the case of a trust or contract that was part of a plan that, on May 5, 1986, did not permit any distributions of employee contributions before separation from service, the pro rata basis recovery rules apply to nonannuity distributions after July 1, 1986. Also, note that a taxpayer's investment in any such trust or contract on December 31, 1986 does not qualify for the special grandfather under section 72(e)(8)(D) and Q&A-13. If such a plan failed to use the pro rata recovery rule in applying the applicable reporting and withholding rules to nonannuity distributions between July 2, 1986 and December 31, 1986, such failure may be corrected (without penalty) by correctly reporting such nonannuity distributions on a Form 1099R or W-2P (whichever is applicable) issued to the taxpayer (and sent to the IRS) for taxable year 1986.

Q-12: When are the taxpayer's investment in the contract and the value of the vested portion of the taxpayer's total account balance in the trust or contract to be determined?

A-12: For purposes of applying section 72(e)(2)(B) to nonannuity distributions from trusts and contracts described in section 72(e)(5)(D), the taxpayer's investment in the contract and the value of the vested portion of the taxpayer's total account balance in the contract are to be determined as of the date of distribution.

Alternatively, a taxpayer's investment in the contract may be determined as of December 31 of the calendar year immediately preceding the calendar year of the distribution and the total value of the taxpayer's vested account balance in the contract may be determined as of the last valuation date in the calendar year preceding the calendar year of the distribution (adjusted as follows) if such date is used on a reasonable and consistent basis in determining such investment and value for all nonannuity distributions under the trust or contract. In lieu of determining the total value of the taxpayer's vested account balance in the contract by using the value of such balance on the last valuation date in the calendar year preceding the calendar year of the distribution (adjusted as follows), such determination may be made by using the total value of such account balance on any valuation date (adjusted as follows) that is during the calendar year preceding the calendar year of distribution but is not more than 100 days before the end of such preceding calendar year if such valuation date is used on a reasonable and consistent basis.

For purposes of determining the total value of the taxpayer's vested account balance, if a valuation date other than the date of distribution is used, the value of the taxpayer's account balance as of the applicable valuation date in the calendar year immediately preceding the year of distribution must be adjusted as follows: (i) the value must be reduced by the value of any distributions from the trust or contract to or on behalf of the taxpayer between the applicable valuation date and the end of the calendar year containing the valuation date; (ii) the value must be increased by the value of any addition (e.g., any employee contributions, employer contributions, and forfeitures, but not income) actually allocated to the contract (or an account that is part of such contract) on behalf of the taxpayer between the applicable valuation date and the end of the calendar year containing the valuation date (including additions that are actually allocated during such period but are allocated as of a date prior to the period); and (iii) the value must be increased by the value of any portion of the taxpayer's account balance that was not vested on the valuation date used by the plan but became vested on a date between such date and the end of the calendar year containing the valuation date (using the value of such portion of the account balance as of the valuation date).

If the plan uses December 31 of the calendar year immediately preceding the calendar year of distribution to value the taxpayer's investment in the contract and a valuation date in the calendar year immediately preceding the calendar year of distribution to value the total account balance in the contract, the Service will use such values for purposes of determining the taxable portion of any distribution and of applying any other rules relating to reporting, withholding, and income inclusion. A plan is not required to contain a provision identifying the method and valuation dates used for purposes of calculating the portion of a distribution that is allocable to the participant's investment in the contract.

Q-13: How does the special grandfather rule for investment in the contract as of December 31, 1986 operate?

A-13: Section 72(e)(8)(D) provides that, in the case of a trust or contract that is part of a plan that, on May 5, 1986, permitted a participant to receive a distribution of any portion of such participant's employee contributions under the trust or contract before such participant's separation from service, the rules of section 72(e)(8)(A) & (B) (as described in Q&A-11 and Q&A-12) shall apply in determining the portion of any nonannuity distribution after December 31, 1986 that is allocable to such participant's investment in the trust or contract only to the extent that the amount of the nonannuity distribution is greater than the remaining amount of the participant's total investment in the trust or contract on December 31, 1986 (i.e., the participant's investment in the trust or contract on December 31, 1986, reduced by nonannuity distributions made after December 31, 1986 and before the date of the nonannuity distribution in question that are not included in gross income on account of section 72(e)(8)(D) and this Q&A). In the case of a nonannuity distribution that is greater than such remaining amount of the participant's investment in the trust or contract on December 31, 1986, the portion of the distribution that is allocable to such remaining amount is to be disregarded in applying the rules of section 72(e)(8)(A) & (B) (and Q&A-11 and Q&A-12) to the portion of the distribution that is greater than such remaining amount.

If a plan (Plan A) that, on May 5, 1986, permitted in-service distributions of employee contributions is merged after May 5, 1986 with a plan (Plan B) that, on May 5, 1986, did not permit such in- service distributions, investment in the contract on December 31, 1986 under Plan A (or the portion of the merged plan that comprises Plan A) will continue to qualify for the special grandfather under section 72(e)(8)(D). Investment in the contract on December 31, 1986 under Plan B (or the portion of the merged plan that comprises Plan B) will not qualify for the grandfather and thus is to be treated under the merged plan, for purposes of section 72(e), as though it is not part of the investment in the contract on December 31, 1986. The same rule applies to transfers of employee contributions between plans.

EXAMPLE 1. Assume that, on December 31, 1986, a participant in a qualified profit-sharing plan that, on May 5, 1986, permitted in- service distributions of employee contributions has a total account balance of $5,000. Assume further that such $5,000 is comprised of $3,000 in employee contributions and $2,000 in earnings, and the participant's investment in the contract equals the participant's employee contributions. During 1987, the participant contributes an additional $1,000 in employee contributions and receives no distributions from the plan. On December 31, 1987, the participant's total account balance is $6,400. The plan does not account for the pre-87 employee contributions separately from the post-86 employee contributions. If the participant receives a nonannuity distribution of $4,000 on January 1, 1988, $3,294.12 of the distribution is allocable to investment in the trust or contract (and thus is not included in gross income) and $705.88 is allocable to income on the trust or contract (and thus is included in gross income). (Assume that section 72(e)(7) does not apply to this profit-sharing plan.) The $3,294.12 portion of the distribution that is allocable to investment in the trust or contract is comprised of (i) $3,000 that is allocable to pre-1987 investment in the trust or contract and (ii) $294.12 that is allocable to post-86 investment in the trust or contract (i.e., determined by multiplying $1,000 times the quotient determined by dividing $1,000 by $3,400).

EXAMPLE 2. Assume that, on December 31, 1986, a participant in a qualified class year plan that, on May 5, 1986, permitted in-service distributions of employee contributions has a total account balance of $9,750. Assume further that such participant's investment in the contract equals the participant's employee contributions. The participant's total account balance is comprised of the following four class year balances:

             Employee Contributions Employer Contributions

MORE -- 87 TNT 3-8 FULL TEXT: ADVANCE NOTICE PROVIDES TEMPORARY GUIDANCE FOR DEFERRED COMPENSATION PLAN DISTRIBUTIONS AND DEDUCTIONS. (Notice 87-13) (Secs. 72, 402, 457 and 2057) (Doc 87-138)

Q-14: What is the effect of section 72(e)(9), added by TRA '86, with respect to determining the portion of a nonannuity distribution that is allocable to investment in the trust or contract?

A-14: Section 72(e)(9) (added by TRA '86) provides that, for purposes of applying section 72(e) to nonannuity distributions, employee contributions (and earnings thereon) under a defined contribution plan are to be treated as under a contract that is separate from the remaining portion of the plan.

A plan may have only one separate contract under section 72(e)(9). Thus, for example, if a plan is otherwise treated as a single contract under section 72, a plan may not be treated as comprising more than two contracts: a separate 72(e)(9) contract for employee contributions (and earnings thereon) and a contract for the remaining portion of the plan (including, for example, employer contributions (and earnings thereon), employer matching contributions (and earnings thereon), and any employee contributions (and earnings thereon) that have not been accounted for separately and thus are not included in the separate 72(e)(9) contract). Furthermore, a plan may not create a separate 72(e)(9) contract for the employee contributions (and earnings thereon) for each year of plan participation. See Q&A-15 for a discussion of the application of section 72(e)(9) where there are undistributed employee contributions on December 31, 1986.

For purposes of applying section 72(e)(9) to a plan, a defined benefit plan is to be treated as a defined contribution plan to the extent that employee contributions (and earnings thereon) to the defined benefit plan are maintained under a separate account to which actual earnings and losses are allocated. If employee contributions to a defined benefit plan are credited with a stated rate of interest, such employee contributions (and earnings) are not to be treated as maintained under a separate account for purposes of section 72(e)(9).

To the extent that a plan does not account for employee contributions (and earnings thereon) separately from the other contributions (and earnings thereon) on an acceptable basis, the employee contributions (and earnings thereon) may not be treated as held under a contract that is separate from the contract (or contracts) that comprises the remaining portion of the plan. Thus, for example, if a plan that is otherwise a single contract under section 72 accepts employee contributions, matching employer contributions, and nonelective employer contributions and does not account for the employee contributions (and earnings thereon) separately from the matching contributions (and earnings thereon), but does account for the nonelective employer contributions (and earnings thereon) separately from such employee and matching contributions (and earnings thereon), such plan will not be treated as having a separate 72(e)(9) contract for the employee contributions (and earnings thereon).

Separate accounting will not be treated as acceptable unless (i) the plan maintains a record for the contributions (and earnings thereon) comprising the separate 72(e)(9) contract that accounts for such contributions (and earnings thereon) separately from the other contributions (and earnings thereon) held under the plan, and (ii) the gains, losses, distributions, forfeitures, and other credits and charges are allocated between the separate 72(e)(9) contract and the other contract (or contracts) under the plan on a reasonable and consistent basis. (Acceptable separate accounting does not require actual segregation or separate investment of amounts.) Thus, for example, separate accounting will not be treated as acceptable if credits and charges resulting from the investment of two classes of contributions (e.g., employee contributions and employer contributions) are not allocated between such classes on a reasonable and consistent basis. Finally, a method of separate accounting will not be treated as acceptable if it is designed to favor the allocation of charges (e.g., losses) to the separate 72(e)(9) contract and to favor the allocation of credits (e.g., earnings) to the contract (or contracts) under the remaining portion of the plan. The Commissioner may provide such other rules as may be necessary to assure that methods of accounting reasonably and consistently allocate credits and charges between separate contracts.

Even though a separate 72(e)(9) contract may not include contributions (and earnings) other than employee contributions (and earnings thereon), a separate 72(e)(9) contract is not required to include all employee contributions (and earnings thereon) under the plan. This is the case even if the employee contributions (and earnings thereon) that are not included in the separate 72(e)(9) contract are accounted for separately from all other contributions (and earnings) under the plan.

For example, if a plan has not maintained a separate account for employee contributions (and earnings thereon) as of a particular date, the plan may not retroactively create a separate 72(e)(9) contract for such amounts. However, the plan may at a specified time commence maintaining a separate account for future employee contributions (and earnings thereon) and thereby create a separate 72(e)(9) contract for such future employee contributions (and earnings thereon). Similarly, even though a plan has separately accounted for employee contributions (and earnings thereon) as of a particular date, the plan may commence maintaining a separate 72(e)(9) contract as of such date for future employee contributions (and earnings thereon). In such cases, however, credits and charges after the commencement of the separate 72(e)(9) contract are not to be allocated only to the separate 72(e)(9) contract comprising future employee contributions (and earnings thereon), but rather must be allocated on an acceptable basis between the separate 72(e)(9) contract and the contract (or contracts) that comprises the remaining portion of the plan (including employee contributions (and earnings thereon) accumulated before the plan commenced separate accounting). Thus, for example, if a plan maintains a separate 72(e)(9) contract for post-1986 employee contributions (and earnings thereon), post- 1986 earnings on pre-1987 employee contributions (and earnings thereon) may not be allocated to such separate 72(e)(9) contract.

In order for a contract to be recognized as a separate 72(e)(9) contract, a plan (or plan procedures) must either specify the contract from which distributions are to be made or permit participants to designate the contract from which a requested distribution is to be made. A distribution will be treated as having been made under the contract to the extent that the plan charges the distribution against such contract (or the accounts that constitute such contract) for plan accounting purposes.

EXAMPLE 1. Assume that, in 1987, an employer establishes a defined-contribution plan to which participants make employee contributions up to 4 percent of compensation that are matched by employer contributions on a dollar-for-dollar basis. Employee contributions (and earnings thereon) are accounted for separately from the employer contributions (and earnings thereon) under the plan and are treated as held under a separate 72(e)(9) contract. The plan provides that, subject to any applicable qualification rules, a participant may receive any portion of the employee contributions (and earnings thereon) or any portion of the employer contributions (and earnings thereon) at the participant's election. The participant makes an employee contribution of $2,500 in each year from 1987 through 1990. In 1991, the participant elects to receive a distribution of $2,000 from the contract comprised of employee contributions (and earnings thereon). Because this contract is treated as separate from the portion of the plan that is comprised of employer contributions (and earnings thereon), the rules of section 72(e) are applied to the distribution of employee contributions (and earnings thereon) by disregarding the participant's employer contributions (and earnings thereon).

EXAMPLE 2. Assume that, in 1987, an employer establishes a class year plan that is treated as a single contract for purposes of section 72. The plan accounts for employee contributions (and earnings thereon) separately from employer contributions (and earnings thereon) on a class year-by-class year basis. The plan treats the employee contributions (and earnings thereon) as a separate 72(e)(9) contract. Assume that a participant makes employee contributions under such plan and receives employer matching contributions and earnings for the first three class years as follows:

             Employee Contributions Employer Contributions

Q-15: How is section 72(e)(9) (added by TRA '86) applied in the case of a participant who has undistributed employee contributions credited to his or her account balance on December 31, 1986?

A-15: To the extent that a plan that, on May 5, 1986, permitted in-service distributions of employee contributions accounts for employee contributions (and earnings thereon) made after December 31, 1986 separately from employee contributions (and earnings thereon) made by such participant on or before December 31, 1986, the plan may treat the separate 72(e)(9) contract as comprising all employee contributions (and earnings thereon) or only post-1986 employee contributions (and earnings thereon). (A plan may commence separate accounting of employee contributions (and earnings thereon) made after another specified date under the rules of Q&A-14.) If the separate 72(e)(9) contract is treated as comprising only post-1986 employee contributions (and earnings thereon), the pre-1987 employee contributions (and earnings thereon) are to be treated, for purposes of applying section 72(e), as held under the same contract that comprises all other amounts held under the plan with respect to the participant (e.g., both pre-1987 and post-1986 employer contributions and earnings thereon), even if the plan accounts for the pre-1987 employee contributions (and earnings thereon) separately from such other amounts. If at any time the plan ceases to separately account for a participant's post-1987 employee contributions (and earnings thereon), such contributions (and earnings) held under the plan on behalf of such participant are to be treated as held under the same contract as the other amounts held under the plan for such participant.

EXAMPLE. Assume that a participant in a thrift plan which, on May 5, 1986, permitted in-service distributions of employee contributions has a total account balance of $8,000 and investment in the contract attributable to employee contributions of $3,000 on December 31, 1986. The plan separately accounts for the $3,000 of employee contributions (and $1,500 of earnings thereon) and the $2,500 of employer matching contributions (and $1,000 of earnings thereon). Beginning in 1987, the plan also separately accounts for employee contributions (and earnings thereon) made after December 31, 1986. Because the plan accounts for the post-1986 employee contributions (and earnings thereon) separately from any other amounts under the plan, such contributions (and earnings thereon) may be treated, for purposes of applying section 72(e), as held under a contract that is separate from the contract under which the $8,000 account balance on December 31, 1986 is held. The plan treats the post-1986 employee contributions (and earnings thereon) as held under a separate 72(e)(9) contract. Thus, the pre-1987 employee contributions (and earnings thereon) and the pre-1987 and post-1986 employer contributions (and earnings thereon) are treated as held under the same contract for purposes of section 72(e) even though the plan also separately accounts for such amounts.

Q-16: If a plan maintains a separate 72(e)(9) contract with respect to a participant, how is such participant's investment or basis under the plan allocated between the separate 72(e)(9) contract and the contract (or contracts) that comprises the remaining portion of the plan?

A-16: Section 72(e)(9) provides for a separate contract for a participant's employee contributions (and earnings thereon), not a separate contract for a participant's investment or basis. As a result, a participant's investment or basis under a plan is not automatically to be allocated to the separate 72(e)(9) contract, but rather a participant's investment or basis under a plan is to be allocated to the contract to which such investment or basis relates. Thus, for example, the investment or basis under a plan that is attributable to P.S. 58 costs or the repayment of a taxable loan under section 72(p) is to be allocated to the contract under the plan to which such costs or repayment relate. If life insurance is purchased with amounts under the separate 72(e)(9) contract, the investment or basis attributable to the P.S. 58 costs is to be allocated to the separate 72(e)(9) contract. If life insurance is purchased with amounts other than those held under the separate 72(e)(9) contract, the resulting investment or basis is to be allocated to the contract that includes such amounts. Investment or basis that relates to amounts held under the contract that includes amounts other than those held under the separate 72(e)(9) contract may not be shifted or allocated to the separate 72(e)(9) contract, but rather must be allocated to the contract including the remaining portion of the plan.

If the separate 72(e)(9) contract under a plan with respect to a participant includes all of such participant's post-1986 employee contributions (and earnings thereon), but does not include any of such participant's pre-1987 employee contributions (and earnings thereon), the participant's investment in the contract on December 31, 1986 is to be allocated to the contract comprising the portion of the plan that is not included in the separate 72(e)(9) contract. However, notwithstanding the preceding paragraph, if the separate 72(e)(9) contract includes pre-1987 employee contributions (and earnings thereon), a participant's investment in the contract on December 31, 1986 is to be allocated to the separate 72(e)(9) contract for such taxpayer without regard to whether such investment relates to such employee contributions (and earnings thereon). In no case, though, may the amount of a participant's investment in the contract on December 31, 1986 that is allocated to the separate 72(e)(9) contract under the preceding sentence exceed the amount of pre-1987 employee contributions (and earnings thereon) for such participant that is also allocated to the separate 72(e)(9) contract.

Finally, if a participant's investment in the contract on December 31, 1986 is less than the amount of such participant's pre- 1987 employee contributions on such date, in applying the separate contract rule of section 72(e)(9), a plan may not treat a portion of such pre-1987 employee contributions (e.g., the portion equal to the excess of the pre-1987 employee contributions over the investment in the contract on December 31, 1986) as though it consists of employer contributions. Thus, to the extent that there has been acceptable separate accounting with respect to the pre-1987 employee contributions (and earnings thereon), such pre-1987 employee contributions (and earnings thereon) must be treated consistently in applying section 72(e)(9), without regard to whether a participant's investment in the contract on December 31, 1986 is greater or lesser than such participant's pre-1987 employee contributions or such participant's pre-1987 employee contributions (and earnings thereon).

The rules set forth in this Q&A apply without regard to whether a taxpayer's investment in the contract on December 31, 1986 is eligible for the grandfather under section 72(e)(8)(D).

Q-17: How does new section 72(e)(9) (added by TRA '86) affect the application of section 72(e)(7)?

A-17: New section 72(e)(9) (added by TRA '86) is to be disregarded in determining whether substantially all of the contributions under a trust or contract are employee contributions for purposes of applying section 72(e)(7). Thus, for example, solely for purposes of making this determination, post-1986 employee contributions are not to be treated as made under a contract that is separate from the remaining portion of the plan. This is the case even if such post-1986 employee contributions (and earnings thereon) are treated as held under a separate contract, pursuant to section 72(e)(9), for purposes of determining the portion of any distribution that is allocable to investment in the contract.

Q-18: How do the basis recovery rules of section 72(e) (as amended by TRA '86) apply to a distribution that is rolled over under section 402(a)(5)?

A-18: Section 402(a)(5) permits a taxpayer to roll over, without current income inclusion, all or a portion of a qualified total distribution or a partial distribution that satisfies certain additional conditions. See Q&A-19. In no case, however, may a taxpayer roll over a portion of a distribution that is greater than the portion of the distribution that is includible in the taxpayer's income. This limitation was not modified by TRA '86.

The basis recovery rules of section 72(e), as amended by TRA '86, provide for a pro rata recovery of a taxpayer's basis with each distribution before the taxpayer's annuity starting date. Accordingly, a portion of each nonannuity distribution under section 72(e) is treated as a nontaxable recovery of basis.

If a portion of a nonannuity distribution is treated as a nontaxable recovery of the taxpayer's basis under section 72(e) (as amended by TRA '86) and the taxpayer rolls over a portion of such distribution (not in excess of the taxable portion of such distribution, as determined under the pro rata recovery rules of section 72(e)) without current income inclusion, all of the taxpayer's basis that is treated as recovered as part of the distribution under section 72(e) is to be allocated to the portion of the distribution that is not rolled over. Thus, the taxpayer is treated as having rolled over only amounts out of the taxable portion of the distribution.

EXAMPLE. A participant in a qualified profit-sharing plan receives a Distribution on separation from service of $3,000 on June 30, 1989. Under section 72(e), $2,000 of the distribution is treated as a nontaxable recovery of the participant's investment in the contract. The participant rolls over to an IRA $600 of the $3,000 distribution. The $600 is less than the maximum amount the participant is permitted to roll over without current income inclusion ($1,000). The $600 that is rolled over is attributable to the $1,000 portion of the distribution that is not treated as a nontaxable recovery of the participant's basis, and thus no basis is treated as rolled over to the IRA receiving the rollover contribution. Of the $2,400 that is not rolled over, $2,000 is treated as nontaxable recovery of the participant's basis and $400 is treated as a taxable distribution.

C. SECTION 402(a)(5)(D)(i) OF THE CODE (SECTION 1122(e)(1) OF TRA '86)

Q-19: What changes were made by section 1122 of TRA '86 to the rules governing the tax-free rollover of partial distributions from qualified plans?

A-19: Before TRA '86, a taxpayer was permitted to roll over to an individual retirement plan, without current income inclusion, all or a portion of a partial distribution from a plan qualified under section 401(a) to the extent that such distribution satisfied certain conditions. Such conditions included, in relevant part, the following: (i) the partial distribution is at least 50 percent of the employee's balance to the credit in the plan of distribution and (ii) the partial distribution is not one of a series of periodic payments.

Effective for partial distributions made after December 31, 1986, section 1122 of TRA '86 modifies section 402(a)(5)(D)(i) by requiring that the following conditions be satisfied in order for a partial distribution to be rolled over without current income inclusion: (i) the partial distribution is a distribution or payment from a trust that is part of a plan described in section 401(a) and is exempt from tax under section 501 or from a plan described in section 403(a); (ii) the partial distribution is a distribution or payment within one taxable year of the recipient of at least 50 percent of the balance to the credit of an employee (determined by application of section 402(e)(4)(C)); and (iii) the partial distribution is a distribution or payment which becomes payable to the recipient on account of the employee's death, on account of the employee's separation from the service, or after the employee has become disabled (within the meaning of section 72(m)(7)). For purposes of this rule (including clause (iii)), the term "employee" includes a self-employed individual within the meaning of section 401(c)(1).

Unless special rules provide otherwise, in determining whether a partial distribution satisfies these conditions and thus may be rolled over without current income inclusion, the rules applicable in determining whether a distribution is a lump sum distribution, within the meaning of section 402(e)(4)(A), will apply. Thus, for example the single election rule of section 402(e)(4)(B) does not apply in determining whether a partial distribution may be rolled over without current income inclusion, but the rules of section 402(e)(4)(C) aggregating certain trusts and plans for purposes of determining the balance to the credit do apply in determining whether a partial distribution may be rolled over without current income inclusion.

D. NEW SECTION 72(t) OF THE CODE (SECTION 1123 OF TRA '86)

Q-20: What additional tax on early distributions from qualified retirement plans applies under section 72(t) (as added by TRA '86)?

A-20: Section 72(t) (as added by TRA '86) applies an additional tax equal to 10 percent of the portion of any "early distribution" from a qualified retirement plan (as defined in section 4974(c) of the Code) that is includible in the taxpayer's gross income. A distribution (including deemed distributions under section 72(p)) is treated as an "early distribution" unless it is described in section 72(t)(2)(A) (taking into account section 72(t)(3) & (4)). A distribution to an employee from a qualified plan will be treated as within section 72(t)(2)(A)(v) if (i) it is made after the employee has separated from service for the employer maintaining the plan and (ii) such separation from service occurred during or after the calendar year in which the employee attained age 55.

A distribution that is an "early distribution" will not be subject to the additional tax to the extent provided under section 72(t)(2)(B) (relating to deductible medical expenses under section 213), section 72(t)(2)(C) (relating to certain distributions from employee stock ownership plans), or section 72(t)(2)(D) (relating to distributions pursuant to qualified domestic relations orders). The determination of whether the additional tax under section 72(t) applies to a distribution is to be made without regard to whether the distribution is treated as a mandatory distribution for purposes of section 411(a)(11) or section 417(e).

The payor (or, if applicable, plan administrator) is not liable under section 3405 to withhold any amount on account of the additional income tax imposed under section 72(t). However, the taxpayer may have estimated tax liability with respect to such additional income tax.

Q-21: What early distributions from employee stock ownership plans are exempt from the additional tax under new section 72(t) (added by the TRA '86)?

A-21: An early distribution made before January 1, 1990 to a participant from an employee stock ownership plan (ESOP) that, for the 5-plan-year period preceding the plan year in which the distribution is made (i) satisfies the requirements of section 4975(e)(7), and (ii) on the average, is primarily invested in employer securities (as defined in section 409(1)) is exempt from the section 72(t) additional tax to the extent that such early distribution is a "qualifying ESOP distribution." In the case of an ESOP that has been in existence for less than 5 full plan years, the full period of existence of the plan is treated as the 5-plan-year period.

For purposes of section 72(t), a tax credit ESOP that satisfies section 409 will be treated as an ESOP that satisfies section 4975(e)(7) to the extent that the benefits under the tax credit ESOP are invested in employer securities subject to the applicable requirements of sections 409 and 4975(e)(7) (other than the requirement that the plan be formally designated as an ESOP and the requirement of continuing exempt loan provisions).

A distribution to a participant will be treated as a "qualifying ESOP distribution" for purposes of the ESOP exception to the section 72(t) additional tax only to the extent that such distribution is attributable to benefits that were (i) allocated to the participant and (ii) at all times during the 5-plan-year period preceding the plan year in which the distribution is made, invested in employer securities (as defined in section 409(1)) that were subject to the applicable requirements of section 4975(e)(7). In the case of a distribution of benefits that have been in existence for less than 5 full plan years, the full period of the existence of such benefits will be treated as the 5-plan-year period for purposes of determining whether the distribution is a "qualifying ESOP distribution."

Thus, for example, if benefits under a non-ESOP are transferred or rolled over to a newly formed ESOP, such benefits will be treated as having been in existence prior to the establishment of the ESOP and thus must have been invested in employer securities that were subject to the rules of section 4975(e)(7) for the full 5-plan-year period preceding the plan year of distribution in order for a distribution of such benefits to be treated as a "qualifying ESOP distribution." If the benefits had been invested in employer securities subject to the section 4975(e)(7) rules under the transferor or distributing plan, the period of such investment in the transferor or distributing plan may be taken into account in determining whether a distribution of such benefits from the transferee or recipient ESOP is a "qualifying ESOP distribution."

For purposes of making the 5-plan-year investment determination under the preceding paragraphs, benefits will be treated as invested in employer securities for the period (not greater than 90 days) between the date that one employer security is sold pursuant to a corporate reorganization or acquisition and the date that another employer security is purchased to replace the prior employer security. In addition, benefits held in cash and cash equivalents are to be treated as invested in employer securities to the extent that the value of such benefits allocated to a participant does not exceed 2 percent of the value of the employer securities allocated to such participant under the ESOP.

For purposes of determining the extent to which an early distribution to a participant is attributable to benefits allocated to such participant that have been invested in employer securities that were subject to the applicable requirements of section 4975(e)(7) for the requisite period, the early distribution is to be treated as attributable to benefits that have been invested in employer securities (as defined in section 409(1)) subject to the applicable requirements of section 4975(e)(7) for the longest periods. Thus, an early distribution to a participant is treated, first, as attributable to benefits that have been invested in employer securities subject to the applicable section 4975(e)(7) requirements for the requisite period preceding distribution (to the extent that such benefits are allocated to the participant); second, as attributable to benefits that have been invested in employer securities subject to the applicable section 4975(e)(7) requirements for less than the requisite period (beginning with benefits that have been invested in employer securities for the longest period); and, third, as attributable to benefits that have not been invested in employer securities subject to the applicable section 4975(e)(7) requirements for any period of time.

For example, if a participant's total account balance under an ESOP is $5,000, and $3,000 of such balance has been invested in employer securities subject to the applicable section 4975(e)(7) requirements for the requisite period under section 72(t)(2)(C), an early distribution to such participant will be treated as a "qualifying ESOP distribution" exempt from the section 72(t) additional tax to the extent that such distribution is not in excess of $3,000. If the early distribution is $2,500, the $2,500 is treated as attributable to benefits that have been invested in employer securities subject to the applicable requirements for longest periods. If the early distribution is $3,500, the $500 that is not treated as a "qualifying ESOP distribution" is treated, first, as attributable to benefits that have been invested in employer securities subject to the applicable requirements for the longest periods (but not for the requisite period), and, second, as attributable to benefits that have not been invested in employer securities subject to the applicable requirements for any period.

In the case of an ESOP under which specific employer securities are not allocated to participants' accounts, but rather, for example, the participants' accounts are credited and charged with units or shares in a pool of employer securities (and other assets), for purposes of determining the extent to which an early distribution to a participant is a "qualifying ESOP distribution," such employer securities must be allocated among participants' accounts in a manner that reasonably and consistently reflects the allocation that would have occurred if specific employer securities (rather than units or shares in a pool) were actually allocated among participants' accounts. Furthermore, an ESOP may not allocate employer securities that satisfy the applicable section 4975(e)(7) requirements under a method that favors the highly compensated employees or employees who are less than 59-1/2.

The same ordering rules are to apply in determining the extent to which distributions that are not early distributions are attributable to benefits that have been invested in employer securities that have satisfied the applicable section 4975(e)(7) requirements.

Q-22: What is the effective date of the section 72(t) additional tax on certain early distributions?

A-22: The section 72(t) additional tax applies to early distributions received in taxable years of individual taxpayers beginning after December 31, 1986. Also, it applies to all such distributions from qualified retirement plans that are described under section 4974(c) (as amended by TRA '86). Section 1123(e) of TRA '86 contains two exceptions to this general effective date rule.

First, the section 72(t) additional tax does not apply to early distributions after December 31, 1986 from an employer-maintained plan (with the exception of an employer-maintained IRA or a simplified employee pension under section 408(c)) to an employee who, as of March 1, 1986, had separated from service with the employer to the extent that such distributions are in accordance with a written election of the employee providing a specific schedule for the distribution of the employee's accrued benefit (e.g., term certain or life annuity) and distributions under such schedule had commenced on or before March 1, 1986. If distributions that commenced in accordance with a written election fail to be made in accordance with the specific schedule contained in the written election as of March 1, 1986, such subsequent distributions fail to be exempt from the section 72(t) additional tax under this exception.

Second, the new section 72(t) additional tax does not apply to distributions of benefits with respect which a designation is in effect under section 242(b)(2) of the Tax Equity and Fiscal Responsibility Act of 1982. If such a designation ceases to be in effect with respect to benefits for any reason (e.g., distributions are not made in accordance with the designation), subsequent distributions of such benefits fail to be exempt from the section 72(t) additional tax under this exception.

E. SECTION 2057 OF THE CODE (SECTION 1172 OF TRA '86)

Q-23: How does section 2057 of the Code, added by section 1172 of TRA '86, affect the sale of employer securities by an estate to an ESOP or eligible worker-owned cooperative?

A-23: Section 2057 of the Code provides that, for purposes of the tax imposed by section 2001, the value of the taxable estate shall be determined by deducting from the value of the gross estate an amount equal to 50 percent of the qualified proceeds (as defined in section 2057(c)) of a qualified sale (as defined in section 2057(b)) of employer securities. Pending the enactment of clarifying legislation, the Service will treat a sale of employer securities by an executor to an employee stock ownership plan or an eligible worker-owned cooperative as not satisfying the requirements of section 2057, and thus the proceeds of such sale will not be treated as qualified proceeds of a qualified sale, unless (i) the decedent directly owned the employer securities immediately before death and (ii) after the sale, the employer securities are allocated to participants or are held for future allocation in connection with an exempt loan under the rules of section 4975 or in connection with a transfer of assets under the rules of section 4980(c)(3). Except in the case of a bona fide business transaction (e.g., a substitution of employer securities in connection with a merger of employers), employer securities will not be treated as allocated or held for future allocation under the preceding sentence to the extent that such securities are allocated or held for future allocation in substitution of other employer securities that had been allocated or held for future allocation. The Service will apply these rules to sales of employer securities (i) after the date of enactment of TRA '86 with respect to which an election is made by the executor of an estate who is required to file a return of tax on a date (including extensions) after such date of enactment and (ii) before December 31, 1991.

F. SECTION 1124 OF TRA '86

Q-24: To what extent may employees treat certain lump sum distributions received in 1987 as though they had been received in 1986?

A-24: Section 1124 of TRA '86 provides a special rule under which certain lump sum distributions received after December 31, 1986 and before March 16, 1987 may be treated as having been received during 1986 for certain purposes. The special rule provides that if an employee separates from service for an employer during calendar year 1986 and receives a lump sum distribution (as defined in section 402(e)(4) of the Code) after December 31, 1986 and before March 16, 1987 pursuant to a plan maintained by such employer on account of such separation from service, the employee may elect to treat the lump sum distribution as if it were received on the date that the employee separated from service. Such a 1987 lump sum distribution that an employee elects to treat as received on the date of the employee's 1986 separation from service is a "section 1124 lump sum distribution."

For purposes of determining whether the distribution or distributions received by the employee constitute a lump sum distribution that satisfies the rules of section 402(e)(4) after December 31, 1986 and before March 16, 1987, such 2-1/2 month period is to be treated as one taxable year of the employee. Aside from this modification, the general rules applicable for determining whether a distribution is a lump sum distribution under section 402(e)(4) continue to apply. This means, for example, that the employee must receive the balance to the credit of the employee (calculated with application of section 402(e)(4)(C)) within this 2-1/2 month period, and no amount distributed during this 2-1/2 month period which is not an annuity contract may be treated as a lump sum distribution unless the taxpayer elects to have all such amounts received during such 2- 1/2 month period treated as a lump sum distribution. In addition, an election of lump sum treatment for distributions received in the 2- 1/2 month period counts as an election made under section 402(e)(4)(B) after December 31, 1986.

If a distribution or distributions received during the 2-1/2 month period qualify as a lump sum distribution under section 402(e)(4) as though such period is a full taxable year of the employee, for the employee's 1986 and 1987 taxable years, the employee may elect to treat such lump sum distribution as though it were received on the date the employee separated from service in 1986. Such an election must be made on a return (or amended return) filed by the employee for the employee's 1986 taxable year by the due date (with extensions) for the return for the 1987 tax year, by attaching a statement that such lump sum distribution is to be treated as a section 1124 lump sum distribution.

If an employee elects to treat a lump sum distribution that is eligible for section 1124 treatment as a section 1124 lump sum distribution, for purposes of determining the tax treatment of such distribution, the distribution is to be treated as though it was the only distribution received by the employee during 1986 from the plan (or plans) making the section 1124 lump sum distribution. Thus, for example, if the employee had actually received a distribution in 1986 and rolled over all or part of such distribution to an IRA, such distribution and rollover may be disregarded in determining the tax treatment of the section 1124 lump sum distribution. In addition, other amounts received in 1986 from the plan (or plans) making the section 1124 lump sum distribution may not be treated as part of the section 1124 lump sum distribution for purposes of determining the tax treatment of such distribution. However, if the employee actually received a separate lump sum distribution in the 1986 taxable year from a different plan (or plans), this separate lump sum distribution and the section 1124 lump sum distribution must be combined and treated as a single lump sum distribution received in 1986.

A section 1124 lump sum distribution is to be treated as received in 1986 for purposes of the applicable income tax provisions (including, for example, the capital gains and averaging rules of section 402) and for purposes of the section 72(t) additional tax on early distributions and the tax under section 4981 (as added by section 1134 of TRA '86) on excess annual distributions. In addition, a section 1124 lump sum distribution is to be treated as received in 1986 for purposes of determining the tax treatment of other distributions received in 1987.

Nevertheless, for reporting and withholding purposes, a section 1124 lump sum distribution is to be treated as paid and received when it is actually paid and received in 1987. Thus, the distribution is to be reported on the Form 1099R for the 1987 tax year. In addition, if the employee does not elect out of withholding with respect to a section 1124 lump sum distribution, the amount to be withheld under section 3405 is to be calculated by reference to the tables applicable for 1987, and any amounts withheld from such lump sum distribution will be credited to the employee's 1987 taxable year, rather than the employee's 1986 taxable year. (An employee may, of course, elect out of withholding on the section 1124 lump sum distribution in order to have funds available to pay the 1986 income tax due with respect to such distribution.) No penalty shall be imposed for failure to pay estimated taxes for the employee's 1986 taxable year with respect to such section 1124 lump sum distribution. However, a taxpayer who elects to treat a lump sum distribution as a section 1124 lump sum distribution will be liable under section 6601 for interest on underpayment of taxes to the extent that the election increases the taxpayer's tax liability for the 1986 tax year and such increased taxes are not paid on or before the last date prescribed for payment of tax for such 1986 tax year.

If a distribution to an employee qualifies as a lump sum distribution and is otherwise eligible for section 1124 treatment by the employee, the payor (or, if applicable, plan administrator) is required to include as part of the explanation required under section 402(f) a statement that such distribution is eligible under section 1124 of TRA '86 to be treated by the employee as received during 1986 and a general explanation of the tax treatment available for such distribution. A general explanation to the effect that a recipient's distribution may be eligible for section 1124 treatment will not be treated as satisfying section 402(f).

G. SECTION 457 OF THE CODE (SECTION 1107 OF TRA '86)

Q-25: What modifications did section 1107 of TRA '86 make with respect to deferred compensation plans under section 457 of the Code?

A-25: Section 1107 of TRA '86 makes several modifications to section 457 of the Code. Among the significant changes are (i) rules coordinating (a) amounts excluded from an individual's gross income under section 402(a)(8) or section 402(h)(1)(B) and amounts with respect to which a deduction is allowable by reason of contributions to an organization described in section 501(c)(18) with (b) amounts deferred under section 457 (section 457(c)(2)); (ii) modifications to the required distribution rules applicable to deferred amounts under eligible plans (section 457(d)); (iii) a special rule permitting the availability of certain distributions of less than $3,500 under eligible plans (section 457(e)(9)); and (iv) a special rule permitting the transfer of deferred amounts between eligible plans (section 457(e)(10)). In addition, section 1107 of TRA '86 generally extended section 457 (with the exception of the 180-day rule contained in the flush language of section 457(b)) to the deferred compensation plans of all tax-exempt organizations (section 457(e)(1)).

Generally, the modifications to section 457 by section 1107 of TRA '86 (including the new coordination rules under section 457(c)(2) and the modified minimum distribution rules under section 457(d)) are effective for taxable years of individuals beginning after December 31, 1988. However, the special rules under sections 457(e)(9) and 457(e)(10) apply to taxable years of individual taxpayers beginning after December 31, 1986. See Q&A-27 and Q&A-28 for the effective date and grandfather provisions for the extension of section 457 to the deferred compensation plans of tax-exempt organizations.

Section 1107 of TRA '86 does not (and was not intended to) amend any provision of Title I of the Employee Retirement Income Security Act of 1974, as amended (ERISA). Accordingly, a deferred compensation plan of a tax-exempt organization may be subject to certain of the requirements of such Title I. In the case of a deferred compensation plan that is subject to Title I of ERISA, compliance with the exclusive purpose, trust, funding and certain other rules will cause the plan to fail to satisfy section 457(b)(6).

Q-26: What deferred amounts are subject to section 457?

A-26: Section 457 (as amended by TRA '86) applies to any amount of compensation deferred under a deferred compensation plan (which includes any deferred compensation agreement and any deferred compensation arrangement, whether or not such agreement or arrangement is individually negotiated), and any income attributable to such amount, between an "eligible employer" (as defined in section 457(e)(1)) and an individual who performs services for the eligible employer.

Section 457 applies to amounts deferred under a deferred compensation plan regardless of whether the plan is in the nature of an individual account or defined contribution plan or a defined benefit plan, including a deferred compensation plan that provides benefits in excess of the benefits provided under a qualified plan under section 401(a), a deferred compensation plan that provides benefits in excess of the benefits permitted to be provided under a qualified plan on account of section 415, and a deferred compensation plan that provides benefits only to a select group of executives or other highly compensated employees (e.g., a "top hat" plan). Also, section 457 applies to amounts deferred even though deferred amounts are determined by reference to factors other than the annual compensation of the individual (e.g., years of service, final average salary), uncertain in aggregate amount, and are payable over an indeterminable period (e.g., over the life of the individual).

Section 457 applies to amounts deferred under a deferred compensation plan, whether or not such deferral is pursuant to the election of the individual taxpayer. Thus, section 457 applies to both elective and nonelective deferred compensation amounts. In the case of deferrals that are at the election of the individual, section 457 applies without regard to whether the deferral election is made prior to the year during which the employee performs the services to which the deferred amounts relate.

Section 457 does not apply to amounts deferred under a plan to the extent that such plan is described in section 457(f)(2), and amounts deferred under a plan described in section 457(f)(2) are not taken into account in applying section 457 to other deferred amounts (except as provided by section 457(c)).

Q-27: When is the extension of section 457 to tax-exempt organizations effective?

A-27: Section 457 (as amended by section 1107 of TRA '86) applies to any amount of compensation deferred, and any income attributable to the amounts so deferred, for taxable years of an individual beginning after December 31, 1986 under any plan of a tax-exempt organization that covers such individual who performs services for the tax-exempt organization. The term "plan" includes any agreement or arrangement between a tax-exempt organization and such an individual. See Q&A-26. Thus, for example, section 457 applies to deferrals of compensation that would have been paid or made available (but for the deferred compensation plan) to an individual by a tax- exempt organization in a taxable year of the individual beginning after December 31, 1986. Similarly, in the case of deferred compensation plan that is in the nature of a defined benefit plan, section 457 applies to deferrals of compensation allocable to taxable years of the individual beginning after December 31, 1986.

A deferred compensation plan of a rural electric cooperative that was treated as a State under section 457(d)(9) (as in effect before TRA '86) is subject to section 457 for certain taxable years beginning before December 31, 1986, as determined under section 457 before amendment by TRA '86. Also, see Q&A-28 for a transition rule for existing deferred compensation plans of tax-exempt organizations.

Q-28: What deferred amounts are within the grandfather rule of section 1107(c)(3)(B) of TRA '86?

A-28: Section 1107(c)(3)(B) of TRA '86 provides that section 457 of the Code shall not apply to amounts deferred under a deferred compensation plan of a tax-exempt organization (other than certain rural electric cooperatives) that are attributable to compensation that would have been paid or made available (but for the deferred compensation plan) in taxable years of an individual beginning before January 1, 1987. In addition, section 457 shall not apply to deferrals of compensation that would have been paid or made available (but for the deferred compensation plan) in taxable years of an individual beginning after December 31, 1986 under a deferred compensation plan of a tax-exempt organization (other than certain rural electric cooperatives) to the extent that such deferrals were fixed pursuant to a written plan on August 16, 1986. For purposes of this grandfather rule, in the case of a deferred compensation plan that is in the nature of a defined benefit plan, deferrals of amounts that are allocable to taxable years of the individual are to be treated as deferrals of compensation that would have been paid or made available in such taxable years (but for the deferred compensation plan).

A deferral with respect to an individual is treated as fixed on August 16, 1986 to the extent that a written plan on such date provided for such deferral for each taxable year of the plan and such deferral was determinable on such date under the written terms of the plan as a fixed dollar amount, a fixed percentage of a fixed base amount (e.g., amount of regular salary, commissions, bonus, or total compensation), or an amount to be determined under a fixed formula. An example of a fixed formula is a deferred compensation plan that is in the nature of a defined benefit plan under which the deferred compensation to be paid to an employee in the future (e.g., on or after separation from service) is in the form of an annual benefit equal to 1 percent for each of the employee's years of service with the employer times the employee's final average salary.

In addition, a deferral with respect to an individual is treated as fixed on August 16, 1986 to the extent that a written plan on such date provided for such deferral and the deferral is the same as the deferral in effect with respect to such individual under such plan on August 16, 1986, even if on such date the written plan did not fix the amount of deferral. Thus, for example, if under a written plan on August 16, 1986, an employee could elect to have up to 5 percent of regular salary deferred and if, on August 16, 1986, the employee had a 5 percent deferral election in effect, subsequent deferrals of the employee's regular salary are to be treated as having been fixed on August 16, 1986 for purposes of this grandfather rule for as long as such deferrals continue to be 5 percent of the employee's regular salary. Similarly, for example, if, under a specified formula in a written plan on August 16, 1986, an employee earned additional deferred compensation amounts for each year of service with the employer, additional deferred amounts attributable to years of service after December 31, 1986 are to be treated as having been fixed on August 16, 1986 for purposes of this grandfather rule for as long as such deferrals continue to be determined under the formula in effect on August 16, 1986.

An amount of deferral that is pursuant to a written plan on August 16, 1986 will cease to be treated as fixed on such date, and thus will be subject to section 457, as of the effective date of any modification to the written plan that directly or indirectly alters the fixed dollar amount, the fixed percentage or the fixed base amount to which the percentage is applied, or the fixed formula. Similarly, an amount of deferral that is pursuant to a written plan on August 16, 1986 that is treated as fixed on such date because it is same deferral amount that was in effect under such plan on August 16, 1986 will cease to be treated as fixed on August 16, 1986, and thus will be subject to section 457, as of the effective date of any modification to the amount of the deferral (i.e., any modification to the specified dollar amount, specified percentage of a specified base amount, or specified formula, whichever is applicable).

A deferral will not fail to be treated as fixed on August 16, 1986 merely because the written plan also provides for a deferral that is not fixed on such date. In addition, a deferral will not fail to be treated as fixed on August 16, 1986 merely because the tax- exempt organization and individual have the right, under the plan on such date, to renegotiate the plan and thus to alter the deferral (whether or not such plan is part of an employment contract between such organization and individual) or merely because the individual has the right, under the plan on such date, to vary the amount of the deferral in the future. However, if at any time after August 16, 1986 these rights are exercised to modify the dollar amount, percentage of a specified base amount, or specified formula (whichever is applicable), deferrals after the effective date of any such modification will fail to be treated as fixed on August 16, 1986 and thus will be subject to section 457.

Even though section 457 does not apply to deferred amounts that are within section 1107(c)(3)(B)(ii) of TRA '86, such deferred amounts are taken into account in applying section 457 to other deferred amounts that are subject to section 457 and are not within section 1107(c)(3)(B)(ii) of TRA '86. Deferred amounts that are within section 1107(c)(3)(B)(ii) of TRA '86, however, are not taken into account in applying sections 403(b), 402(a)(8), 402(h)(1)(B), and 501(c)(18).

Q-29: What is the effect of section 457(e)(9) (as added by TRA '86) on section 1.457-1(b) of the regulations?

A-29: Section 457(e)(9) operates as an additional exception to application of the constructive receipt rules to allow an eligible plan to permit a participant with respect to whom the present value of the total amount under the plan does not exceed $3,500 to elect to receive the such total amount under the plan in a lump sum. Section 457(e)(9) does not limit the elections otherwise allowed under section 1.457-1(b) of the regulations.